Chinese Dollar/Yen Swap Buyers Face Payout Risk

Chinese banks and state-owned enterprises are trying to restructure U.S. dollar/yen swaps that will have them paying out millions of U.S. dollars if the cross breaches JPY80 barrier and the yen continues to appreciate.

Chinese banks and state-owned enterprises are trying to restructure U.S. dollar/yen swaps that will have them paying out millions of U.S. dollars if the cross breaches JPY80 barrier and the yen continues to appreciate.

The counterparties entered the swaps with convex payouts in the mid-2000s, when the cross was trading above 100, an official familiar with the trades said. The swaps, most of which have notionals in the hundreds of millions of dollars, are tantamount to the Chinese banks selling protection on the appreciation of the yen to a foreign counterparty. As long as the pair stays above 80, the Chinese banks earn 1-2% of the notional from the foreign banks at fixed payment dates. If the yen appreciates beyond 80, the banks must then payout one minus the spot price divided by 80 times the notional at the fixed pay dates. As of press time, the pair sat at JPY84.095, up from a more than 10-year low of JPY80.35 Oct. 29.

If the yen continues to appreciate, they could be in serious trouble, the official said. The Chinese protection seller has limited upside, but unlimited downside, there is a knock-in, but no knock-out. The tenors of the trades tend to be 10-15 years, the official said. Even though the barrier has not been hit, the official said that many of the trades are already out of the money based on their mark-to-market values. The cross hasnt hit 80 in more than 15 years and at the time, the deals seemed like a safe play, the source said.

Last year, a number of commodity derivative contracts between foreign banks and SOEs blew up, resulting in a combined loss of USD2 billion for the Chinese entities, and leading to some banks asking for warranties to be written into OTC contracts (DW, 12/8). As the trades were blowing up, the China State-owned Assets Supervision and Administration Commission of the State Council sent a notice saying that SEOs could walk away from those "bad" transactions and another Chinese agency froze the permits that allowed the Chinese banks to pay their foreign counterparties, forcing the international banks to restructure the deals, according to the official.

Its not a high possibility, but its not beyond the realm of imagination either, the official said of the possibility of the government freezing these trades. The international banks dont have any incentive at the moment to restructure these deals or lower the barriers, the official said. The official declined to name any banks involved in the deals, on either side. Two other officials confirmed the existence of the trades and the attempts to restructure but also declined further comment.

Eddie Wang, head of fx structuring at Crédit Agricole Corporate and Investment Bank in Hong Kong, said while the dollar/yen could drop to JPY80 in the near term thanks to a market focus on the U.S. quantitative easing measures and reduced risk appetite, that in one year the pair will rise towards JPY90 or JPY95 in two years because of structural problems in Japan. In the longer term, maybe its not such a big problem given our views, he said. Based on our forecast, these structures may not become a huge problem as long as dollar/yen doesnt drop below 80 for an extended period of time. He declined to give a forecast beyond two years from now.